Archive for the ‘Investment Banking’ Category
Wednesday, December 7th, 2011
With all eyes focused on Jon Corzineâ€™s testimony relative to MF Global Thursday, perhaps it might be time to consider that MF Global might only be one act to consider in this multi-act and often undisclosed tragedy.
The whispered story of private citizen Corzineâ€™s toppling of a regulator at the Commodity Futures Trading Commission (CFTC) is something to which light should be shown.Â In fact, the battle that took place in the late 90s between then CFTC Chairwoman Brooksley Born and then Goldman Sachs Chairman Jon Corzine, who is said to have directed lobbying efforts and the Washington D.C. â€śWorking Groupâ€ť to dispense with the â€śirascibleâ€ť Ms. Born.Â This is a story that has dramatically impacted society, leaving a scare of undisclosed leverage that can even be seen in todayâ€™s debt crisis.
What surprises me most about this story is the fact that it has generally remained untold.Â Hopefully at Mr. Corzineâ€™s congressional hearing tomorrow tough questions, listed at the end of this article, will bring forth additional details regarding the actions of Mr. Corzine and the Working Group.
Mr. Corzineâ€™s tale really should be told by considering a pattern of behavior where the Goldman superstar ignored advice of risk managers and arrogantly rolled over regulators, literally toppling those who dare question his methods of non-transparent leverage management.Â Contrast this to Ms. Bornâ€™s efforts to simply make the leverage transparent and traded on an open, regulated exchange and consider what was left in the wake: the explosion of Long Term Capital Management, the Enron debacle, the deceptively wrapped mortgage credit default swaps that imploded in 2008, and the fireworks display to end Mr. Corzineâ€™s career, MF Global.
To the determent of society, Mr. Corzine has utilized undisclosed leverage throughout his career in a way that is yet to be properly recorded.Â Ms. Bornâ€™s story is simply one her trying to enforce basic derivatives management practices vs Mr. Corzineâ€™s â€śnew schoolâ€ť attitude that bended or broke rules that the U.S. citizen simply didnâ€™t think applied to him or his colleagues at Goldman Sachs.Â If you think it was a fair fight between a principled regulator with old school derivatives management philosophy and a Wall Street oligarchy, I have a trading floor to sell you.
This article addresses how powerful private enterprise forces controlling the levers of financial engineering literally ran through regulators on their quest to impose their unsustainable methods of leverage management on society.
Mr. Corzineâ€™s Rolling of Brooksley Born
Brooksley Born was a demure lawyer, well known and highly respected in the derivatives industry during an era of time when derivatives industry experience mattered at the top of the Commodity Futures Trading Commission (CFTC).Â Upon taking over at the CFTC on August 26, 1996, life-long derivatives industry executive Ms. Born likely never though her career would abruptly end less than three years later, forced from office by the powerful financial services lobby.
Ms. Born discovered an issue that might similarly catch the attention of many in the derivatives industry if they were in her shoes.Â She discovered massive undisclosed leverage in mortgage derivatives over the counter trading and wanted such potentially toxic assets to transparently disclose their contents and be traded on a regulated exchange. Â Logical enough. Â The regulator then dispatched Michael Greenberg, head of the divisions of trading and markets, to simply prepare a list of questions to be answered about the over the counter market.Â The document asked questions and raised issues regarding previous industry fraud, potential default and market collapse and the growth of the OTC industry.Â This internal CFTC document was titled the â€śConcept Releaseâ€ť [link:http://www.cftc.gov/opa/press98/opamntn.htm] and was designed to be nothing more than a thought piece.Â Little did Ms. Born recognize that freedom of thought might get her in trouble with the financial oligarchy.
â€śI thought asking questions couldnâ€™t hurt,â€ť Ms. Born was later quoted as saying. â€śI was shocked at the strong negative reaction to merely asking questions about a market.â€ť
The Concept Release was said to be shock to the system in both New York and Washington D.C.Â It was at this point private citizen Corzine is said to have called the â€śWorking Groupâ€ť into action, an elite club of financial engineers who determined the future of the world economy.Â Operated at a high level by the likes of Â Robert Rubin with Alan GreenspanÂ and Larry Summers at his side, the group was said to have a second layer of devotees with tentacles that spread throughout all major economic levers of power in Washington D.C. Â In response to the Concept Release, Working Group leader Robert Rubin called an emergency meeting of group participants to muster support for silencing Ms. Born.
Concept Release now public, it was the summer of 1998 and Born started testifying before Congress.Â She simply told the truth about transparency and unregulated derivatives â€“ and the financial oligarchy really became uncomfortable.Â Ms. Born warned about how mortgage derivatives traded in unregulated over-the-counter markets lacked transparency and could explode upon the economic landscape. SuchÂ hereticalÂ talk enraged the working group.
Silencing the Principled Regulator Because She Requested Transparency
The orders to the working group were clear: silence the regulator who is requesting transparency and OTC derivatives trading on open markets.Â The Working Groupâ€™s first tactic was arm twisting.Â Ms. Born was first called before Goldman alumni Robert Rubin, who flatly told Ms. Born her agency lacked the authority to regulate derivatives, a move that had some in the derivatives circles shaking their heads in disbelief of Rubin’s remarks.Â This didnâ€™t stop Ms. Born, so the working group turned to the next man on the enforcer list, who happened to be then SEC chairman Arthur Levitt. Â Mr. Levitt’s attempts at persuasion wereÂ similarlyÂ unsuccessful. Â Thus, the third hitter up to bat was Alan Greenspan.Â In published reports, Mr. Greenspanâ€™s face was said to have turned red during the meeting as she told Ms. Born of dire consequences if mortgage derivatives were made transparent.Â Ms. Born held her ground, and the phone lines between D.C. and New York were ablaze with talk of â€śteaching Ms. Born a lesson.â€ť
With the Working Groupâ€™s favored behind the scenes leverage tactics experiencing surprise rare defeat, they turned to overt pressure through Congress.Â Later that year Born received her rebut from Congress, the censure of her powers.Â She later resigned from office effective June 1, 1999 and Mr. Corzine had drawn the blood of his first federal regulator.
One note about the financial oligarchy is that while members may be individually brilliant, the notion that thought on issues can be independent isnâ€™t always valued.Â The group mind think at the time was that non-transparent leverage was positive for the economy (or at least there was sufficient profitability in the deceptive mortgage derivative products to make it positive).Â Thus, any attempts to shine light on proper derivatives management were outed.
This shouldnâ€™t have been a big issue; â€śold schoolâ€ť derivatives management dictated that proper leverage management was transparent and traded on open exchanges.Â Unfortunately for society, this is when Born ran into the â€śnew schoolâ€ť of derivatives management, one that didnâ€™t feel any need for transparency, eschewed disclosure into the actual leveraged components and thought trading on regulated exchanges was a burdensome detail. In short, Ms. Born was introduced to Mr. Corzineâ€™s philosophy.Â It was this moment, newly minted CFTC chairwoman Brooksley Born fought an unexpected a battle between â€śold schoolâ€ť commodities management and a powerful new school that would soon silence the demure regulator â€“ and any future regulator that dared challenge the Wall Street power base.
With a history of rolling over regulation, Mr. Corzineâ€™s behavior with MF Global should come as no surprise, but the financial oligarchy he lead has not always come out on top.
Wall Street Doesnâ€™t Get Its Way All the Time â€“ Just Most of the Time
To be clear, there have been rare successes when the derivatives industry has faced off with equity interests.Â One highly visible example took place when German futures exchange, Eurex, looked to take control futures on the U.S. yield curve in the early 2000â€™s. This effort of off-shore control of futures trading on interest rates, backed by Goldman Sachs, was one of the rare points when the commodity industry successfully fought off Goldmanâ€™s powerful Wall Street force.
In this instance, the whispered story that emerged years after the event was one of the financial services industry and Washington D.C. saying NO to Goldman Sachs.Â At the time of this fight, Goldman wasnâ€™t the current omnipresent force it is now.
Significant preparation for the fight with Eurex was said to take place, but a generally calm approach was taken by those at the top of the CBOT.Â In stories that have emerged long since the event occurred, the real battlefield was said to take place at a dinner in Washington D.C. and private meetings in New York.Â In Washington D.C. a simple argument was said to be made: U.S. control of futures on the yield curve could one day prove to be strategically critical at some future point.Â Fast forward to 2011, with a debt crisis swirling around, this derivatives industry warning could be viewed as accurate.Â In this case, influential forces in Washington recognized the logical argument regarding national interest.Â This was also a time when the omni-potent force of Goldman Sachs did not prevail, to the surprise of some.Â After successful meetings in D.C., the New York meetings were said to have a different tone.
The D.C. argument was said to be different than the equity industry argument.Â In stories that have emerged years after the events took place, CBOT officials were said to gather the major Wall Street players with the exception of Goldman Sachs, of course.Â The core argument was made that it simply wasnâ€™t appropriate for Goldman Sachs to have such omnipresent control over the U.S. futures markets and the financial industry at large.Â Such accurate and prophetic words, as the battle was won but the war was lost.
In short, the battle over the U.S. yield curve was won by the U.S. futures exchanges, racking up a rare loss for Goldman Sachs.Â But ironically the omni-present control by one financial services firm continues.Â With Goldman Sachs now the un-disputed heavyweight champion in financial circles in both New York and Washington D.C., it is ironic that their leader, the man who as a private citizen helped draw first blood from a regulator, was now in front of Congress after a reign of terror through the halls of MF Global.
Betting on a Bailout and Benefiting from â€śWorking Groupâ€ť Connections
Upon taking over at MF Global, Mr. Corzine was said to show little if any interest in the industry in which his firm operated.Â The derivatives markets and its old school methods of leverage management were of little concern, even less concern than were regulators.Â Perhaps it is for this reason when the CFTC gave MF Global a warning regarding toxic sovereign debt over a year before the firm declared bankruptcy, that warning could have been so easily ignored by Mr. Corzine along with warnings form MF Global internal risk managers.Â Instead, Mr. Corzine is said to have relied on inside whispers from contacts in Washington D.C.Â U.S. Treasury Secretary Timothy Geithner is said to have re-assured Mr. Corzine that European bonds would not be allowed to drift into default.Â In other words, Mr. Corzine could ignore the warnings of regulators so as to rely on another government bailout to support his adventures in sovereign debt.Â Â The rest, as they say, is history.
With this as a backdrop, perhaps it is time to get answers to important questions on the record.
Questions that Congress should Ask Mr. Corzine
Mr. Corzine, you were warned on the risk in your positions on several occasions. First, you violated an old school risk management principal to diversify risk away from one significant economic headwind.Â That diversification technique might not be as â€śsexyâ€ť as concentration of risk towards positive economic outcomes, but it tends to work well in a variety of market circumstances.Â Here is the big question: How many times were you warned the risk in your sovereign debt position was too much exposure in one direction?Â Who were the people that warned you regarding sovereign debt and when did those warnings take place?Â Did the CFTC provide MF Global a specific warning regarding sovereign debt?Â Why was that warning ignored?
When U.S. Treasury Secretary and former Working Group member Timothy Geithner visited Wall Street this year, what was the focus of conversations?Â Did Mr. Geithner assure you that governments in Europe wouldnâ€™t be â€śallowedâ€ť to collapse? How did reliance on a government bailout impact your decision relative to highly leveraged investments in sovereign debt?
Mr. Corzine, describe your relationship with regulators and regulation in general.Â Specifically, what discussions did you have with a â€śWorking Groupâ€ť in Washington D.C. regarding the deposition of Brooksley Born as CFTC Chairwoman?Â The first tier of Working Group participants has been placed in the public domain.Â Will you name the second tier of the Working Group and disclose their current positions in the U.S. Government?
Mr. Corzine, the American public finds itself in debt crisis that as early as this summer many in the public didnâ€™t really recognize.Â Â It seems to me that the level of leverage and methods to manage this leverage have pretty much been undisclosed.Â Â I would like your recollection of how undisclosed leverage was defended in 1998 during fights with CFTC Chairwoman Brooksley Born, and then more appropriately how undisclosed leverage led to the downfall of MF Global?Â Â Can you tie together your involvement in the following and specifically touch on how undisclosed leverage was a factor in the demise of Long Term Capital Management, the mortgage / credit crisis of 2008 and your current situation at MF Global?
Mr. Corzine, if you can reflect on the past 15 years of your career, a period of time when one Wall Street financial services firm with one groupthink mentality clearly dominates financial decision making in governments across the world, can you assess the impact undisclosed leverage might have on societyâ€™s future?
Mark H. Melin is author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and was an adjunct instructor in managed futures at Northwestern University. Â Follow him on Twitter @MarkMelin.
Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors. Â Past performance is not indicative of future results.
The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.
Wednesday, November 16th, 2011
To say the MF Global situation is a mess may be the understatement of the century. What began as an excuse to extol the segregated account’s safeguards against an FCM stock slide as MF Global shares lost 70% of their value in a week rapidly morphed into a full-fledged industry disaster as bankruptcy papers were filed and executives acknowledged a shortfall in those previously sacrosanct accounts.
This admission, in conjunction with the bankruptcy, has caused over $5 Billion of customer funds held by MF Global to be frozen, unable to be accessed or transferred out.Â Right on cue, the lawyers have begun to circle, with employees, bondholders, and the customers themselves filing claims for their piece of the $40 Billion in Assets MF Global reportedly had on hand.
What was a very small probability just two weeks ago now looks to be a near certainty â€“ that over 150,000 futures industry customers who held accounts at MF Global will have their money locked up for anywhere between several months to several years. Before a single penny can be distributed, a legal team charging $1,000 an hour will have to go line by line through books that have been described by regulators as a “disaster,” making the potential (and incentive) for a speedy turnaround non-existent. Even then, once the books have been closed on the accounting side, the legal battle royale begins, and if theÂ Sentinel case is any indication, we’ll be waiting for quite a while to run through all the cases,
My firm, Attain Capital, uncomfortable with the direction MF Global was taking, moved all of its accounts from MF Global 2.5 years ago. Even with that foresight, we have had clients close their accounts in the MF Global aftermath because they are worried about the safety ofÂ their segregated funds, while many others heatedly question what the industry is going to do to make sure this never happens again.
While the lawyers fight with JP Morgan over who should get what money (how would you feel about being a taxpayer who bailed out the big banks only to have them get priority over your money in bankruptcy?), the rest of the industry needs to be talking about how to salvage our collective business.
Many of you may be feeling lucky you didnâ€™t have exposure to MF Global, or even enjoying an uptick in business because of the MF Global accounts being transferred to you, and that’s understandable. However, that joy becomes short-lived as one realizes that this mess threatens theÂ continued growth of not only your firm, but our entire industry.Â Brokers, CTAs, service providers, technology companies, and more will all go out of business because of this â€“ some immediately because they wonâ€™t get their most recent payments due from MF Global, and others over the next several months as their business falls due to their client base’s inability to access the funds held at MF Global that they need to trade.
But the biggest threat is to the future. It’s that large investor whoÂ would have happily opened a futures account just a month ago, but now chooses not to because he is unsure what would happen to his funds should a bankruptcy occur at his broker of choice.
How do we make sure that such an investor regains confidence in the industry, and chooses to go ahead with that investment? The hollow emails by FCM presidents and owners to their clients saying theyÂ care is simply not enough; actual solutions and fixes to the problems which allowed the MF Global mess to happen need to be enacted.
The industry needs to change to protect that which was formerly held most dear â€“ the segregated account. Here is what we propose:
Create a coalition to make all the MF Global customers whole, immediately.
There are billions of dollars of profits between the exchanges, brokerage firms which just received free business from the MF Global demise, and others in the industry.Â Someone (ahem… CME) Â needs to step up and create a coalition of these industry giants and pony up the money to make each and every one of the MF Global accounts whole, immediately.
If the government didnâ€™t think that MF Global was too big to fail, the industry surely needs to. Do you think the CME put forth their $250 million guarantee or $50 million recovery fund out of the kindness of their hearts? No- they are worried about volumes, and rightfully so. With about $5 Billion worth of customers now unable to trade, the sooner those customers can pump those funds back into the markets, the better for the CMEâ€™s bottom line.
How is this supposed to work? Weâ€™re not saying this coalition needs to pony up the money and never get repaid. Weâ€™re saying they should step in and cover the money until the bankruptcy runs its course and the funds are released.Â Why canâ€™t the industry put together a fund which covers the customer segregated funds, and in exchange for making the customer whole, the customer signs over any claim they had to their money in bankruptcy court to the fund?
Think of it more asÂ fronting the money. After all, nearly all agree that it is just 10% or so of the money which is missing.Â At worst, the fund would be out the $600 million in missing segregated funds (and that’s only if the trustee is unable to get any of the $41 Billion in MF Global assets to cover that shortfall). The problem here is less about there beingÂ no money than it is about the money being frozen up.
The industry simply canâ€™t afford to wait for the bankruptcy to run its course. Every moment of inaction that passes is a moment without those funds coursing through the industry’s veins. Consider that MF Global reported in its Q2 financials that it cleared 575 million contracts over the three months that ended June 30th, 2011.Â IfÂ the exchanges are getting $0.25 per contract, without taking action, thatâ€™s aboutÂ $575 million in lost revenues per year. If the brokers who just received the accounts could get $0.25 per contract on the business moved to them, thatâ€™s $575 million inÂ new revenue for them (assuming those accounts can get back trading).
There is plenty of money to go around, especially in the name of saving what has been the cornerstone of this industry since its inception-Â the sanctity of the segregated account. Hell, Attain will even pony up our share. Without taking this step, there is little any of us can do to help our clients feel secure. Industry participants will likely be worried about setting a precedent, but that is, in fact, the whole point. We need to be able to point to this time in our industryâ€™s history and say,Â “Yes, it was ugly, but the industry stepped in and made the accounts whole.”
If youâ€™re still not on board, why not backstop the coalition fund with a rule granting the ability to increase NFA fees from the current $0.02 per trade to $0.03 to cover any shortfall the fund has to cover? And as a final brushstroke, how about making the coalition memberâ€™s investments in the fund count 100% towards their net capital computations, treating it like cash in the bank?
The choice is a known cost in a temporary, defined and shared burden or an unknown cost in an inequitable and unquantifiable loss of business in the long run. Howâ€™s that for risk calculation?
While this may put out the fires in the short-term, at the end of the day, there’s still much more work to be done. It’s not enough to simply react; we need to be proactive about preventing this from ever occurring again. How? We’re glad you asked.
1. Extend SIPC protection to futures investors. When it came to light that the SIPC was rapidly moving to ensure that all claims to the assets of MF Global were resolved, the initial reaction of many industry participants was to breathe a sigh of relief. However, as many soon found out, SIPC protection is currently only offered to securities customers- meaning only those trading stocks and bonds would be covered, and not our beloved exchange traded futures investors. In our minds, there isÂ zero reason why investors in traditional asset classes should be afforded such protection while investors in the alternative space are not.
As such, we propose that regulations governing the SIPC be amended to ensure protection of futures clientsâ€™ holdings as well, with guarantees on the individual account level (the sub-account of the customer segregated account on the FCMâ€™s books) and not just the main overall account level containing all of the customer funds.
The CME and ICE should cut 10% off their marketing budget and put that to lobbying Congress for this protection. This isnâ€™t 1970, when stocks and bonds were the only game in town. If the world turns to the CME to manage risk, the CME needs to turn to Congress to lower the risk of managing that risk.
2. Amend CFTC rule 1-25 to limit segregated funds investment to US Treasuries only. One of the issues that’s gotten a lot of press since the shortfall in funds at MF Global went public is the idea that Corzine might have used those funds to finance his European bets. There’s no proof of this yet, but the concept alone rattled many. The general belief was that FCMs could not, under any circumstances, touch segregated funds.
That’s not true. Under 1-25, FCMs are allowed to gain interest on excess segregated funds through specific investments under explicitly outlined circumstances. There are three limitations that really matter here: preservation of capital, preservation of liquidity, and adherence to risk standards.
Under the rule, FCMs can invest in 6 different vehicles (U.S. treasuries, state bonds, government agencies, commercial paper, corporate notes or bonds, sovereign debt, and money market mutual funds), but, with the exception of U.S. Treasuries or money markets, these vehicles have to have the highest rating possible from one of the NRSROs- or, official ratings agencies. This means that, technically speaking, the allegations flying around that FCMs may legally use segregated funds to invest in high-risk junk bonds are utterly incorrect. That being said, we’re still not satisfied with the requirements.
If we learned anything from 2008, it is that ratings agencies were doling out the highest ratings possible on toxic mortgage-backed securities right up to the point that things blew up. In fact, the rating agencies even downgraded MF Globalâ€¦wait for itâ€¦.Â after they went bankrupt.Â Our trust in their ability to assess risk adequately enough to ensure the preservation of segregated client funds is nil. As such, our recommendation is that 1-25 be amended to prohibit investment of segregated account funds in anything but U.S. Treasuries. While a statement issued today by CFTC Commissioner Scott O’Malia pointed out that we do not know the root cause of the missing funds, and that it’s possible the missing funds have nothing to do with investments permitted under 1-25, in our minds, this changes nothing; this rule needs to be altered regardless of the MF Global investigation’s conclusions.
3. Â Establish regulation under which language must be added to all creditor agreements for any registered FCM in which those creditors agree to the assignment of the customer segregated accounts as the primary lien holder on all assets of the company. Under current provisions, segregated accounts are given what is, in our minds, inadequate protection during the bankruptcy process. True, their accounts cannot be tapped to meet outstanding financial obligations of the bankrupted FCM, but there’s also no guarantee of those funds being made whole in the event of a shortfall, nor protection from a too big to fail bank like JP Morgan sending in armies of attorneys arguing that their claim should take precedence over the customers.Â While clients may, after a pro-rata distribution, file a claim with the Trustee in an attempt to get their missing money back, it appears that there are back door methods for big creditors like JP Morgan Chase and those who held MF Global bonds to get in front of the customers in the claims process. AsÂ TheStreet summarized:
“The group of customers, led by James Koutalas, chief executive of a Chicago-based commodities trading firm, are taking issue with a lien and other protections offered to JPMorgan in exchange for a $8 million loan the bank extended to MF on the first day of its bankruptcy, according to the report. That would allow JPMorgan the right to some assets over other creditors.”
In our minds, segregated account holders should absolutely come first in the claims process. Unlike the creditors and bold holders, who knowingly accepted the risk of default when they handed over their money, MF Global clients were paying MF Global to hold their funds- not lose them. With this in mind, we believe that the law must designate segregated accounts as the primary creditor if an FCM goes belly up, ensuring that, should there be a shortfall in client segregated funds, available assets of the bankrupt FCM will be tapped to make those accounts whole before any other creditor gets their day in court.
You can be sure that the big creditors would take an immediate and very big interest in insuring that any FCM they lend money to has the adequate procedures and safeguards in place to protect customer funds knowing that they are second in line behind said customer funds. If you canâ€™t rely on morality to protect the funds, rely on greed and the invisible hand of those who would stand to lose money should the customer segregated funds be breached.
4. Establish regulation outlining standard operating procedures in the wake of an FCM bankruptcy. Part of the reason that the MF Global situation has been so chaotic was the result of poor planning. Positions were stuck in limbo. There was no infrastructure for facilitating an orderly transfer of accounts, which led to an ad-hoc distribution among arbitrarily selected FCMs without the transfer of legal documents- including those necessary for a CTA to trade on behalf of a client. Without any stipulations regarding timeframe, the process was drawn out to the detriment of all parties involved. Add to that a failure to effectively communicate what was going on to the clients involved, and it’s no wonder the situation turned into the nightmare it did.
In the wake of both the Refco and Sentinel scandals, one would think that remedies would already have been put into place for such administrative Bermuda Triangles, but unfortunately, that did not occur. In order to prevent such a disorderly dissemination from occurring again, we suggest that new regulations be developed; outlining exactly what is to happen in the event of an FCM going bankrupt. The old plan seemed to be, wait for a suitor to step up and take on all of the accounts. That clearly worked out wonderfully this time around. Coming up with standard operating procedures outlining the immediate impact on open positions, where the client funds are to be transferred to and within what timeframe, and so forth would help avoid the confusion we’ve seen to date.
A Call to Action
We are not about to claim that we have all the answers. Have we researched these subjects? Yes. Have we consulted with others in the industry? Absolutely. Does that mean that the solutions proposed here are perfect? NO.
But someone needs to start the dialog. The CME has made a nice first step with its $250 million guarantee to the trustee. The efforts of Koutoulas and Roe to provide a voice for the clients in the bankruptcy proceedings are certainly admirable. But at the end of the day, we all know that there is a long road ahead of us. Laws need to be changed and rules rewritten. Â The industry needs to step up and reclaim its image. At the end of the day, perception is all that matters. If this situation is not resolved effectively, every CTA, FCM, CPO, Commodity Broker, Introducing Broker and Exchange will lose a sizable amount of business. There’s no getting around it. People aren’t going to invest in something where they don’t feel secure.
Make no mistake- these are extraordinary times we face, and they require an extraordinary communal effort to be survived. Despite the challenges on the horizon, we have no doubt that, in one way or another, this industry will rise to the occasion.Â Because as important as it may be to understand what’s transpired and what’s at risk here,Â what comes next matters even more.
CAIA Â | Â CEO, FOUNDING PARTNER
ATTAIN CAPITAL MANAGEMENT, LLC.
Thursday, November 10th, 2011
Goldman Sachs and Morgan Stanley reportedly are considering ending mark-to-market accounting for some loan commitments, a practice which Reuters Breakingviews editors say puts them at a competitive disadvantage.
The story originally appeared in The Wall Street Journal this morning.
“It’s a little bit overblown,” Breakingviews columnist Antony Currie says of the reporting on the change. “It’s not the entire portfolio. It’s actually a very small amount they’re considering changing, and that is the loan commitments they make to investment grade companies.” (more…)
Friday, November 4th, 2011
‘Repo to maturity’ transactions are in substance total return swaps, a type of credit derivative. Fallout is worse than Lehman for the exchange-traded futures market.
The “repo to maturity” transactions are in substance total return swaps, a type of credit derivative. So MF failed to meet margin calls on credit derivatives linked to risky fixed income debt. Regulators haven’t learned much from AIG’s debacle. Like the “repo to maturity” transaction, a total return swap is an off balance sheet transaction treated as a sale, but the total return receiver, MF Global, is long both the price and default risk of the reference assets. The total return payer is the legal owner of the reference assets. The attraction of this arrangement is financing and leverage. Naturally, ratings downgrades will trigger increased margin calls. This is all business as (un)usual.
MF Global Admitted “Diverting” Money from Segregated Accounts
What isn’t usual is diverting money from segregated customer accounts. It’s too late to blame “sloppiness, bookkeeping, or accounting,” MF Global admitted it “diverted” money from customers’ segregated accounts.
The fact that MF Global was exposed to default risk and liquidity risk because of these trades and that they were linked to European sovereign debt was disclosed in MF Global’s 10K for the year ending March 31, 2011, a required financial statement filed with the SEC. The CFTC and other regulators had the information right under their noses, but it appears they didn’t understand that they were looking at a leveraged credit derivative transaction that could lead to margin calls that MF Global would be unable to meet.
Even if all the money can eventually be recovered, it doesn’t change the fact the MF Global took impermissible steps.
Here’s a crazy but true side note. Michael Stockman, the chief risk officer of MF Global (as of January 2011), was in our Liar’s Poker training class lampooned by another classmate, Michael Lewis.
More Liar’s Poker
Last week when customers asked for excess cash from their accounts, MF Global stalled. According to a commodity fund manager I spoke with, MF Global’s first stall tactic was to claim it lost wire transfer instructions. Then instead of sending an overnight check, it sent the money snail mail, including checks for hundreds of thousands of dollars. The checks bounced. After the checks bounced, the amounts were still debited from customer accounts accounts and no one at MF Global could or would reverse the check entries. The manager has had to intervene to get MF Global to correct this.
Rogue Trader and Questionable Risk Management
Gary Gensler, Jon Corzine’s former Goldman Sachs colleague and current head of the Commodities Futures Trading Commission (CFTC), had reason to be concerned about MF Global’s risk management. In early 2008, a rogue trader racked up $141.5 million in losses in unauthorized trades that exceeded his trading limits. It seems he accomplished this in under seven hours. In August of this year, MF Global and the underwriters of its 2007 initial public stock offering (IPO) paid around $90 million to settle claims by investors that they were misled about MF Global’s risk management prior to the rogue trader’s actions. Since 2008, MF Global’s financial condition has been nothing to brag about.
CFTC’s Unprecedented Failure to Move Customers’ Assets Before FCM’s Bankruptcy
The exchange-traded futures markets have been shaken to the core. The Bankruptcy Code apparently conflicts with the Commodity Exchange Act, so customers of MF Global have less protection than they otherwise might have had. In the past, the exchanges and CFTC “always” moved customer positions before a Futures Commission Merchant (FCM) declared bankruptcy. The CFTC had ample reason to have contingency plans for MF Global based on publicly available information. Yet the Gensler-led CFTC hasn’t followed this historical precedent when an FCM led by his former Goldman colleague teetered on the edge of bankruptcy.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago’s Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).
Reprinted with permission. The original post can be found here.
Wednesday, November 2nd, 2011
Reuters Breakingviews columnists break down how the Dodd-Frank financial regulatory reform legislation still wouldn’t have caught problems at a smaller firm like MF Global.
“Clearly MF Global is not going to be considered a systemically important institution, so those rules … even those rules are very sketchy in terms of what they do that’s new,” said columnist Reynolds Holding. (more…)
Wednesday, November 2nd, 2011
While weâ€™re almost getting sick of writing about MF Globalâ€™s problems, we are still getting calls from concerned people, and the situation is far from resolved. There are still no clear answers coming out of the MF Global mess. Reports yesterday were all over the board, with quotes coming out of government agencies intermeshed with quotes coming out of the hearing on the non-broker-dealer side of MF Globalâ€™s business, causing even more confusion for people trying to figure out what in the world was going on. Itâ€™s a convoluted rumor mill, but as far as we can discern, hereâ€™s whatâ€™s up:
- An anonymous source from the regulators camp is reporting that MF Global officials admitted Monday to using client funds in the midst of the turmoil. No official confirmation from anywhere else just yet.
- The FBI is now involved and investigating.
- The SIPCÂ has set-up the preliminary website for filing claims and has started to put the wheels in motion. Based on our understanding, this does not apply to segregated futures accounts- only to securities clients of MF Global.
- In the initial bankruptcy hearing yesterday, the MF Global attorney stated that all funds, â€śto the best knowledge of management,â€ťÂ but that the subject of the hearing did not relate to the matter because they werenâ€™t discussing the brokerage business.
While the idea of fraud with segregated accounts on this kind of scale is unprecedented (even if it is only 10% of the total funds in segregated accounts with MF Global), the reaction, in our opinion, could have still been handled a heck of a lot better. Regulators and industry participants alike have floundered in the aftermath, leaving investors uninformed (or misinformed) and scared. Even if you do get a hold of someone at one of the regulatory agencies, you probably arenâ€™t going to get a straight answer- aside from, â€śWe donâ€™t know.â€ť
One of the more disturbing questions that no one seems to be effectively answering is whether this is a systemic problem across the futures industry.Â That is, are other FCMs comingling their money with customer money? In our opinion, the answer is a most definiteÂ no. The problem with MF Global, from our view, was that it turned its back on its primary futures brokerage business upon Corzineâ€™s entry in an attempt to transform into an investment bank, which in turn led to a chain of events whichÂ may have led to them using client money to plug holes in their balance sheet.
To our knowledge, that kind of direction is not prominent in the industry. And indeed,Â some FCMs were reaching out to clients yesterday talking about how they are not involved in such trading. Â In our view, every futures-focused FCM (like RJO, RCG, PFGBest, etc. â€“ not the investment banks like Goldman Sachs which also hold FCM status) realize that, in a world where their bread and butter comes from their brokerage clients, the clientsâ€™ happiness and security of funds is paramount. Â In our view, unless there is/was an industry-wide switch to an investment bank model like Corzine tried, then there is no risk of industry-wide problems such as those at Corzineâ€™s firm.
With that in mind, perhaps the more pertinent question was raised inÂ a post on Dealbreaker from Matt Levine. He postulates:
The main fallout will probably be that if you have the choice to work with a too-big-to-fail bank or a just-small-enough to fail bank, on a whole variety of things, youâ€™re going to go too-big-to-fail. Sure, there are lots of small brokers who are well capitalized and take the time to get the little things right, like segregating customer accounts. But how can you know unless you do a lot of diligence? Easier to just trust that a megabank squarely in the regulatorsâ€™ sights will get it right â€“ or, if they get it wrong, wonâ€™t be allowed to blow up in a way that blows up customers.
There are three things worth noting here.
- For many in futures trading, MF GlobalÂ was one of the big dogs. Maybe not a Goldman Sachs, but hey- even Corzine was betting they were too-big-to-fail. Everyone assumed that everyone else was on top of things because of how big MF Global was- despite the fact that they had long since departed from the purpose that had fueled their ascent.Â This is the 8th biggest bankruptcy in US history â€“ making it hard to believe being too small was the problem here.
- Even if you accept the premise that being at a megabank is the only place to be (because thatâ€™s where the bailouts are), the problem is you really canâ€™t be a futures trader at the top half-dozen banks without being a hedge fund which slings 1,000 lots around like it is nothing. Â The megabanks donâ€™t have an infrastructure to handle retail futures accounts trading on their own or through managers.
- The problem with due diligence on FCMs is, in the case of MF Global, traditional due diligence might not have raised any red flags. Their audits had gone off without a hitch. They had seamlessly responded to capitalization calls earlier this year. Their reporting was looking good. And then, all of the sudden, it wasnâ€™t. Outside of gaining access to all of their accounting records (and good luck with that), what kind of due diligence could have prevented this?
Our take? We believe the situation unfolding with MF Global is not indicative of failure in the system, but an isolated blow-up related to the decisions made by management regarding the companyâ€™s focus. There are no easy answers here, and the repercussions of any fraud at MF Global could shake the futures industry for years to come- but is this common among futures-focused FCMs? Absolutely not. MF Global went a different direction than the rest of the industry, and that is why these problems exist, in our opinion. It isÂ what they were doing- not of the industry they were doing it in.
Perhaps if Corzine had succeeded, we would have seen more FCMs try and copy that success, but the failure bodes well for the health of the industry now, being a stern warning for any firms which decide to juice their returns by dabbling in other areas.
To read more Managed Futures research pieces, visit Attainâ€™s Managed Futures Newsletter archive and our Managed Futures Blog.
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Monday, October 31st, 2011
Traditionally staid and conservative firm seeks buyers as concentrated bets in European Sovereign debt markets go badly wrong
In an episode of art imitating life, the movie Margin Call depicts a financial services firm that concentrated all its risk in one sweeping bet that went badly wrong. In the case of the movie, the trade that exploded in the debt markets of 2008 forced a financial services firm to liquidate assets in an attempt at survival. Fast forward to October 2011, and MF Global, one of the industryâ€™s leading Futures Commission Merchants (FCM), is struggling for survival as it receives a real life margin call. As of this writing the New York Fed suspended conducting business with the firm and more significantly the CME Group has cut off trading access to the firm.
The eighth ranked FCM in 2010 with $8.6 billion under management, MF Global was, like many futures brokerage firms, following staid and conservative management principles that generally didnâ€™t gamble company assets through proprietary trading. (In 2008 when a rogue Wheat trader made headlines by racking up $145 million in losses, such unauthorized trading wasnâ€™t part of the firmâ€™s management plan.)
Things changed rather dramatically during spring of 2010. This is when a gambler took the reins of power. As a result, the company is currently scrambling for liquidity to raise cash while its leader, former Goldman Sachs superstar Jon Corzine, might be looking at the numbers to figure out what went so very wrong. This might be similar to 1994 when Mr. Corzine was co-lead of Goldmanâ€™s fixed income group when it posted losses that almost took down the investment bank. But upon reflection, it looks more like the 2008 car wreck then NJ Governor Corzne was in while speeding down the expressway without a seat belt.
What Went Wrong?
With a University of Chicago background, a school known for producing strong quantitative minds, Mr. Corzine really needs to look no further than another U of C alumnus, Nobel Prize winner Harry Markowitz, to figure out why things went so bad so quickly.
As MF Global, one of the leading brand names in the futures and options industry, fights for oxygen and liquidity, Mr. Corzineâ€™s significant concentration of risk towards a single market move in Sovereign debt highlights what is known as investment concentration. This means all risk in a portfolio might be influenced by one significant macro global force. In this case, when the credit markets in Spain, Portugal and Ireland logically fell apart without significant austerity measures in place, the bond investments and the fortunes of MF Global all lost value at the same time. This investment concept stands in contrast to Markowitz, whose Modern Portfolio Theory promoted the concept of asset diversification of returns streams, a cornerstone of proper derivatives risk management. Mr. Corzine might have missed that diversification memo.
There are several points of derivatives risk management Mr. Corzine and his well connected crew have ignored. Perhaps the most significant also was related to a debt issue. While at Goldman Sachs, Mr. Corzine and those designing non-transparent derivative products were witness to a warning from a demure female with a powerfully strong will: Brooksley Born.
Ms. Born was CFTC Chairwomen when, in 1998, she sounded alarm bells regarding non-transparent and toxic derivative products that were not managed in accordance with open, transparent and regulated rules that existed in the exchange traded derivatives markets. While she and her prophetic call for transparency into toxic assets were generally ignored â€“ and she was effectively muzzled by a â€śWorking Groupâ€ť in Washington D.C. that existed of the likes of Alan Greenspan, Larry Summers and former Goldman alumni Robert Rubin and Timothy Geithner â€“ Ms. Born eventually resigned office on June 1, 1999. The toxic assets to which Ms. Bornâ€™s warnings were targeted famously exploded in fall of 2008. Ms. Born, her ignored warnings now vindicated, nonetheless keeps professionally quiet on the topic, letting facts speak for themselves.
The History of a Debt Crisis
After losing re-election as Governor of New Jersey in 2009, Mr. Corzine set his sights on making his mark in the derivatives world again when he replaced former Chicago Board of Trade president Bernard Dan as CEO of MF Global on March 23, 2010. While his results at MF Global were similar to his re-election attempt, Mr. Corzine made a different choice in the derivatives markets this time around. Instead of non-transparent off-exchange mortgage derivatives, Mr. Corzine chose the regulated derivatives industry when he took the reins at an FCM that had deep historic roots tracing its roots dating back to 1783 when English commodity trader James Man founded the firm. Little did anyone know at the time MF Global, long considered an industry icon of sorts, was now on a path to being sold off in bits and pieces in a fire sale to the highest bidder.
Upon taking control at MF Global, Mr. Corzine had two choices: he could gamble, rolling the dice on a heavy concentration to Sovereign debt, or he could have chosen the path of popularizing a defensive investment portfolio that includes a diversity of returns streams â€“ a concept championed by a host of academic thinkers and investment practitioners. Mr. Corzineâ€™s choice speaks to a lost opportunity at this moment in economic history.
In choosing to gamble with Sovereign debt assets over focus on integrating uncorrelated investments into traditional stock and bond portfolios, Mr. Corzine wasnâ€™t looking to the future, which is unfortunate. Upon taking over MF Global, he quickly stated his long term vision was one of logical asset management, transforming the FCM into the next big thing on Wall Street. This gave those in the managed futures industry reason to cheer. In the end, however, he couldnâ€™t overcome his past where significant risks were taken â€“ some that worked, some that didnâ€™t. The difference between Goldman Sachs and Corzineâ€™s MF Global is that Goldman often takes the both sides of trades â€“ as they did in the mortgage derivatives crisis. At least they embrace the concept of diversification of risk and returns streams. Mr. Corzineâ€™s concentration concept just didnâ€™t work out.
â€śYou shouldnâ€™t risk more than you can lose,â€ť noted veteran industry observer John Lothian. â€śThis goes for traders as well as brokerage firms.â€ť
Whatâ€™s interesting here, the overlooked component is that Mr. Corzine gambled from within the futures industry which is known for â€śgambling.â€ť However, the opportunity Mr. Corzine missed is the industry is really based on risk management and hedging, not raw speculation. The growing futures industry movement is away from raw gun-slinging speculation, to embracing logical asset management with an investment generally uncorrelated to the stock market through managed futures. It is an industry increasingly looking like an insurance company with probability tables and less like that represented by the Wild West and a gun slinger attitude of investment concentration. Unfortunately Mr. Corzine chose making his highly concentrated leveraged bets in Sovereign debt markets rather than expanding the concept of uncorrelated investments.
Itâ€™s in the uncorrelated investing concept that many on Wall Street seem to have problems. Perhaps it was the message about an investment that operates independent of economic strength that just didnâ€™t jive with Mr. Corzine? Or it could have been the industry concept of account segregation and transparency where he might have missed the derivatives management memo? Clearly the defensive concept of true diversification didnâ€™t resonate.
There is a movement in the futures and options industry away from the cowboy speculator and towards a logical and risk-focused investment. This is the direction many had hoped Mr. Corzine would take MF Global, the brokerage firm once considered industry legend. But that, apparently, isnâ€™t going to happen.
As Mr. Corzine and Company are managing their margin call, liquidity drying up all around them, the opportunity to expand the concept of diversification with investments uncorrelated to the performance of the stock market might have received a temporary set-back. However, as a looming US government debt crisis that wonâ€™t go away easily becomes better understood by those including Mr. Corzine, the concept of true asset diversification is something that should not be ignored at this moment in economic history.
Mark H. Melin is currently writing his fourth book on uncorrelated investing. Â He is previous author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and an adjunct instructor in managed futures at Northwestern University. Â He can be reached at firstname.lastname@example.org
Contents of this article Copyright (C) 2011 Mark H. Melin.
Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors. Â Past performance is not indicative of future results.
The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.
Tuesday, October 18th, 2011
The Occupy Wall Street protesters and their sympathizers are catching a lot of grief from well, people who work on Wall Street, and from some members of the media friendly with those who work on Wall Street. They say the protests lack reasonable goals and there is no clear end-point. One might also surmise there is a sense of unease about having several hundred people who don’t like you and despise your line of work camped outside your office day-in and day-out.
And yet, it’s not just the camped-out protesters who sense things are amiss in the world of finance. Paul Brodsky of QB Asset Management told Barron’s the protesters are “credible,” and that they represent “a ‘disenfranchised majority that is quickly growing disenchanted’ with our financial system and its workings.”
Kynikos Associates’ Jim Chanos and PIMCO’s Bill Gross have said they understand the protests. Chanos told Bloomberg on Oct. 11, “People are angry, they feel the game is rigged and they didn’t get their fair shake.”
Citigroup’s Vikram Pandit called the protesters’ sentiments “completely understandable.”
And just today, Leon Cooperman of Omega Advisors without explicitly saying he supported Occupy Wall Streetâ€”who knows, maybe he doesn’tâ€”leveled some of his own criticism of the markets. Cooperman said at the Value Investing Congress in Manhattan that high-frequency trading “has turned the market into a casino,” and that he supports the return of the uptick rule to do away with it, as well as limits on who can participate in the credit default swap markets and reining in speculation in exchange-traded funds. (more…)
Wednesday, October 12th, 2011
Keefe, Bruyette and Woods’ analyst Brian Gardner says complying with the new Volcker rule will be a bigger headache for banks than lost revenue from banning proprietary trading.
“Banks have never really disclosed with great specificity exactly what prop trading is and what percentage of their business is involved,” Gardner says. “The GAO did a study that came out several months ago, and they looked at the losses and profits over, I think it was a four-year period, and for the major banks, if you look at the numbers, they were not that large. I mean, they were, you know, we’re talking about billions of dollars in profits over a multi-quarter period spread over several banks. So my guess is, and I’m not a fundamental analyst, but sitting from a policy chair my guess is that the impact on the business models is not going to be as great as people have feared.” (more…)
Wednesday, September 21st, 2011
U.S. banks must acknowledge their stark outlook, says CLSA’s Mike Mayo, who predicts low yields and high expenses will usher in the worst decade of revenue growth since the Great Depression.
“It’s when banks don’t recognize the reality and try to grow faster than the natural rate of growth in the environment, that’s when they get into trouble,” Mayo says. “So it doesn’t have to be life-threatening that banks don’t have very good revenue opportunities, but in response banks need to show risk discipline and also control their costs.” (more…)